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Tuesday, June 21, 2011

Larry Swedroe Makes the Case for Passive Investing

I had the pleasure of listening to Larry Swedroe speak last night about the benefits of passive investing. Swedroe is the Director of Research for the Buckingham Family of Financial Services, is the author of several solid books on investing, and writes the Wise Investing blog.

Many arguments about the merits of passive and active investing boil down to ideology, but Swedroe doesn’t bother with ideology; he looks at data. He is driven by the science of investing and answers his critics with data. If someone comes along with data showing that some active strategy can beat the market, then he can be convinced. But he has seen precious little such evidence.

An interesting statistic Swedroe gave was that while passive investing among institutional investors has gone from 15% to 60% over the last 25 years, among individual investors the number using passive methods has only gone from 1% to 15% over those 25 years. Perhaps institutional investors know something that most of the rest of us don’t know, yet.

Another statistic was that 90% of all trades are made by big institutions. So when you buy a stock, odds are strong that a big institution sold it to you because they thought it was better not to own the stock. Do you really think you can know more about the business you’re buying than a large institution?

Apparently being smart doesn’t help. A Mensa investing club underperformed the market by almost 13% per year for 15 years! This is a brutal result. This means they were left with about one-eighth as much money as they would have had if they had invested in the index.

A closing remark from Swedroe was that active investing “is the triumph of hype, hope and marketing over wisdom and experience.”

17 comments:

I'm an active investor. CAGR in 20 years of investing of 18% versus a TSX passive return of 6%. You have to distinguish between active investing with intelligence and active investing with ignorance. The Mensa people you quote failed because they thought their knowledge exempted them from doing the hard work of investment research. I doubt that they read annual or industry reports.

Don't be disheartened by the fact you are competing with big institutions. They are hobbled by the actions of their clients. In the mutual fund industry, it has been found that two negative quarters of poor performance and redemptions start to rise. The fund managers chase short term performance or lose their clients.

I should note here that alpha is zero sum. Whereas beta is available to everyone by indexing or buying randomly, alpha gained by one active investor is alpha lost by another active investor.

And no, it is not a function of intelligence. As Buffett has said, the most important quality for an investor is temperament, not intellect.

As Buffett has said, "The market is a wealth transfer mechanism, it transfers wealth from the less informed to the more informed."

Those who learn the skills of value investing and do their research should do well.

@Ahmed: All available evidence says that the performance you describe is exceedingly rare. I don't believe that your conclusion is correct. My guess is that most people who "learn the skills of value investing and do their research" will underperform the market due to costs (making the return from their hard work a negative amount). That said, there will always be a minority who outperform due to luck.

Swedroe has a vested interest in convincing people to hire him so that he can charge a management fee for passively investing clients money.

There is no convincing him that Modern Portfolio Theory is going to be left in the dust.

He does not grasp the importance of owning real insurance (options) for a portfolio. He still believes that diversification and asset allocation are at the top of the list of what investors need for safety.

Sure passive may beat active for most investors. But that is not the point.

The bottom line is that passive investing is not good enough.

There is too much downside risk. There is the fact that once uncorrelated investments are becoming more correlated in a global economy.

@Mark: After having met with Swedroe, I believe that he could be convinced of anything if it is backed up with hard data. However, if that data is skewed in some way, he is definitely smart and dogged enough to figure it out. I have understood your arguments on a qualitative level, but I would need to see the quantitative evidence that investors can achieve a better risk-reward trade-off using stock options.

The majority of active investors lose money because they are not actually investors but rather speculators. You have to define your terms.

Benjamin Graham said: "An investment operation is one which upon thorough analysis promises safety of principal and an adequate return, operations not meeting these requirements are speculative."

Most so called investors are doing armchair analysis or chasing past performance or using metrics that don't work. In other words, they have no clue what they're doing. As such, they expose themselves to risk without adequate compensation.

BTW, you'd be hard pressed to convince a speculator that they are not actually investors. In the old days, market participants were classified as being either speculators or investors. But because speculation had negative connotations, now the investment industry uses the terms "retail investor" and "professional investor". The speculator is now called by a euphemism.

@Ahmed: If professional investors make the kind of returns that you talk about, then the only way to define "professional investor" is after the fact. By this I mean that you decide whether an investor is professional or not after seeing his or her past investing results. Any investor who can reliably beat the market by 10% can become a billionaire fairly quickly by opening a hedge fund. To avoid the problem of short-term thinking, the hedge fund would just place restrictions on when money could be pulled out.

Michael, not all of us wish to to be billionaires. Beyond a modest lifestyle, I have no need or desire for money.

The joy of investing is its own reward. If you look at Buffett, he continues to work even though he has billions,which for the most part, are going to charity. He says he tap dances to work each day.

Yet Buffett lives a very modest lifestyle. He goes home at the end of the day and watches TV with a bowl of popcorn, or plays bridge, etc. He obviously isn't doing it for the money.

The performance I describe is very rare because few people follow the principles of value investing. All the great investors including Buffett are the disciples of Benjamin Graham, usually referred to as the dean of security analysis.

The concept of value investing is very simple but hard to put into practice: "Buy a bargain and wait". Specifically, we look for a 30% discount to intrinsic value.

As for luck, using empirical evidence, if luck was a factor and the Efficient Market Hypothesis was valid, you'd expect to see construction workers, busboys, etc. on the Forbes 400 richest people after excluding those who made their money in areas other than investing. But you don't.

I would agree with you that you can't pick winning money managers in advance. By the time you have enough evidence of their returns through various economic cycles, they're probably close to retirement.

@Ahmed: Millions try to implement the "buy a bargain and wait" strategy. For many their failure is not one of temperament but one of failing to compute intrinsic value better than the market does.

I don't buy your argument about busboys on the Forbes 400. How many on the Forbes 400 got there by investing? Even Buffett's wealth has come from a healthy dose of business success in addition to his investing success.

I won't say that skill in investing doesn't exist. But it is exceedingly rare and I doubt that it is simple.

I'm on the active side, and I think it can be successful. I believe Ahmed when he says he has beat the market handily.

I think Buffett also said if he were starting out today, he would be able to make 50% per year.

I also agree that most shouldn't be active investors. Temperament and correct analysis are both important. It's probably worth repeating the obvious, that regardless if you are a passive or active investor, fees are of utmost importance. This means keeping trading costs, activity (due to bid/ask spreads) and taxes (activity plays a role here too) low.

If we could all trade for free, with no taxes and no spreads, half would beat the market, half would trail. Costs skew the average to below the indexes.

Sorry, I just realized I was incorrect when I said half would beat and half would lag the market. On average, investor returns would equal the market. Probably still most people would lag the market due to bad trading based on emotion, buying high and selling low.

“The most important quality for an investor is temperament, not intellect. You don’t need tons of IQ in this business. You don’t have to be able to play three-dimensional chess or duplicate bridge. You need a temperament that neither derives great pleasure from being with the crowd or against the crowd. You know you’re right, not because of the position of others, because your facts and your reasoning are right.”

Now to clarify, Buffett did not say that temperment was the only quality required, only that it was the most important quality. You need other skills like understanding "accounting and the nuances of accounting"( his words) and be willing to spend the time to inform yourself about the business you're buying.

As an investor, I'm always amazed at the reasons people buy a stock, like "this guy on TV said..., "I heard from a friend of a friend", "everyone says this stock is hot", etc. Seriously, you can't make this stuff up. These people should be passively investing in index funds if they're not willing to commit the time to do the research.

@Gene: Your point about costs is important. No matter what type of investor you are, fees and other costs make a big difference.

@Ahmed: I remember a lot of people buying stocks for silly reasons back during the tech boom. Unfortunately, even people who try to apply sound principles usually trail the index over time.

@Mark: I understand your point about guaranteed limits on losses using stock options. The question in my mind is whether the price of this guarantee is reasonable. To take an extreme example, betting equally on all 38 numbers on a roulette wheel guarantees a loss of no more than 5.3%. The problem is that you can't do any better than losing 5.3%. With options there is an upside, but I've never been able to devise an option strategy that left enough upside for the approach to be worthwhile. This may be because of a lack of knowledge on my part. However, I won't venture into options until I'm satisfied (with data) that I know a viable strategy.

Passive investing does make sense for the vast majority of people. But for others like Ahmed who are willing and able to develop a modicum of natural talent into the technical and temperament skills to invest successfully, active investing make much sense. Indeed, all the passive investors should be thanking the good active investors for bringing prices back into line with real value. The "it is impossible to outperform" statement founded on the fact that it is rare and statistically indistinguishable from chance forgets the old but true cliche "there are lies, damned lies and statistics".